1. Field of the Invention
The present invention relates to a design, computer implemented method, a computer-based system, and computer program product for the design and operation of an investment contract or an insured annuity contract that credits interest on principal in a manner relating to equity returns while offering protection of principal. More particularly, the present invention relates to a computer implemented method, computer-based system, and computer program product for creating and implementing a Group Equity-Indexed Annuity (GEIA) with a guaranteed minimum equity related return for a set of participants in 401(k) plans and other tax qualified and non-qualified group savings arrangements.
2. Description of the Prior Art
Various types of investment vehicles are available to individuals including, but not limited to, stocks, bonds, real estate, commodities, annuities and mutual funds. Each of these investment vehicles yields the investor a given combination rate of return and level of risk. While young investors can tolerate a higher level of risk in their retirement savings accounts since they have many years to recover from losses, retired individuals and individuals near retirement have a lower risk tolerance. This is because principal on which they are relying to recover from an investment loss is being constantly depleted for living expenses. The future income plans of individuals in or near retirement can be critically disrupted by even modest investment losses. Accordingly, retirees and individuals near retirement need to minimize or avoid investment losses.
A type of fixed annuity contract currently available to individuals, called an Equity-Indexed Annuity (annual ratchet type), addresses this problem. The individual EIA contract provides a guarantee of principal plus interest, at least equal to the requirements imposed by the state insurance Standard Non-Forfeiture Law, while also promising alternative interest credits equal to a percentage of the increase (i.e., positive change) in a standard equity index, like the S&P 500 without dividends (S&P). As a result, an individual annual ratchet type EIA contract delivers equity related returns while offering protection of principal and guaranteed interest. Very high loads and carrier discretion over benefits (i.e., interest crediting) currently characterize the individual EIA contracts available in the retail marketplace.
The individual EIAs that exist in the retail market (e.g., those sold to individuals by agents and brokers) are designed with various features. The impact that these features have on interest credits, minimum guarantees, loads, and liquidity (i.e., the ability to make penalty-free withdrawals) will ultimately drive customer satisfaction or dissatisfaction. Aside from the minimum interest guarantees, surrender charges, and loads, the two features that have a large value impact are the “participation rate” and the “indexing method”. Indexing methods vary from product to product. Three are in common use, including the annual resets (ratchets), the point-to-point, and the high-water mark. In most cases, equity-linked interest is credited, over a pre-defined term, using one of these methods.
Participation Rates
The participation rate determines how much of the index increase will be credited. For example, a 50% participation rate means the individual will receive ½ the increase in the equity index during the measurement period credited as interest. In the annual ratchet design, this equity related interest would be credited every year. In the point-to-point design the interest crediting is calculated using the change from point A (contract issue) to point B (say, 7 years after issue). The participation rate is reset annually in the annual ratchet EIA design. For the point-to-point design, the participation rate is set for the point-to-point period. At the end of the period (annually for the annual ratchet deign), the participation rate may change. How participation rates change is not always disclosed in the retail (i.e., individual) market. There are several possible reasons for this. First, the reset process is complex—both to explain and understand. Second, a full explanation requires complete disclosure of fees and margins. Third, some carriers want to retain flexibility to increase fees and margins in the future, without the problems that may come with communication of the fee increase. In the retail market, absent more restrictive regulatory controls, the reset process is likely to remain in the proverbial “black box.”
Interest Credits May be Limited
Some retail EIA designs place limits on the interest credited. For example, if the participation rate is 75% and the equity index, for example, the S&P, delivers a 40% return over the measuring term, the calculated participation rate would be 30% but the contract may limit the interest credited to, say, 10%. These limits are called “rate caps” or simply “caps.” As another example, the contract may credit 100% of the increase in the index, but cap the interest credit to, say, 10%. With some EIA designs, the change in the index may be measured by using an average of the index values, instead of the index value on a particular day. Some contracts credit interest using a “simple interest” basis instead of compound interest. With simple interest, only the original contribution grows with interest. In other words, interest credits do not grow with interest. Each of these design features play a key role in how the contract will perform relative to the buyer's expectation. For example, buying the point-to-point design at the start of a bull market may create dissatisfaction if the reset “point” comes in the middle of a bear market. If the individual tries to withdraw contributions invested before the end of some “holding period” (e.g., essentially a “maturity” date), surrender charges make it economically painful.
Early Withdrawals are Charged Exit Fees
Surrender charges vary from EIA contract to EIA contract. However, most EIA contracts are designed to provide “free” access for small withdrawal requests, such as up to 10% per year, and “free” access for death. In general, the charges for other premature withdrawals can be quite high, in some cases in excess of 10%. These charges, of course, accrue to the benefit of the carrier. Some EIA contracts are also designed to provide access using an “imputed” market value calculation. This calculation, while intended to be fair, could be confusing and difficult for individual buyers to understand and also exposes the individual to significant economic loss.
Early withdrawals may also cost the carrier because sales expenses, amortized over a period of, say, five to ten years, must be recovered from the amount withdrawn. Otherwise the carrier could realize a loss. However, insurance laws provide protection for the consumer. By law, carriers are required to pay minimum surrender values, and thus, collect no more than some pre-specified maximum surrender charges. The minimum surrender values required by the Standard Non-forfeiture Law (SNFL) are meaningful, but still unattractive to many consumers. In a typical case, for example, the law requires a guarantee that each $100 contributed (i.e., invested) can be surrendered at a value equal to $87.50 plus interest at 2.85% per year. Even with these relatively low surrender values, the carrier is still at risk of not fully recovering its contract acquisition expenses.
Carrier's Asset Strategy for the Retail EIA
In implementing an EIA contract, the carrier invests the premium in bonds and a portion of the anticipated interest on those bonds is advanced and used to buy one-year call options on the measuring equity index, say the S&P. If the interest that can be advanced from the bonds is 4.00%, the contract's participation rate is dependent on how many call options the carrier can buy with the $4 of interest (per $100 of premium). If the price of the call option is $5 per $100 of S&P value, the participation rate is 80%. At the end of the year, the call option will expire worthless if the index is down. But, if the index is up, the call option will provide the “payoff” needed to credit the proper interest. In either case, the carrier will have sufficient assets to pay the customer what was promised. This asset/liability management process is repeated each year for the term (or holding period) of the contract (at which point the surrender charges no longer apply).
The participation rate for the EIA is, in effect, a hedge ratio. The participation rate depends on the amount of money spent by the carrier (4% in our example) and the price of the call options. If call options cost $8 per $100, then the carrier can “hedge” 50% and pay the customer 50% (participation rate) of the positive change in the equity index. The amount of money used to buy options ($4) is a function of the interest available on the bonds purchased. The carrier wants their bond portfolio to return the original $100 in a year's time. Therefore, if bonds deliver an annual yield of 4.16%, the carrier could, at the beginning of the year, afford to “advance” (i.e., spend) one year's interest toward the purchase of call options. The interest advanced ($4) merely represents the discounted, or current, value of the interest it expects to receive on the bonds at the end of the year. This “advanced” interest is commonly thought of as “interest available”. The insurance company has no control over option prices. If option prices increase, but bonds were locked into a yield of 4.16%, then the participation rate will fall.
Accordingly, there is a need for a method, system and computer program product for minimizing the undesirable aspects of an EIA contract—the undisclosed process for resetting participation rates, high surrender charges, and very restrictive liquidity. There is a need for the EIA contract to be for a set of participants and guarantee a minimum participation rate, while also offering a reasonable profit margin to the carrier. There is a need for the method, system and computer program product to minimize downside risk with respect to the purchase of EIAs to be available to a plurality of individuals. There is a need for the plurality of individuals to be participants of a group sponsored savings program (either tax qualified or non-qualified). There is a need for the method, system and computer program product for minimizing downside risk with respect to the purchase of EIAs to carry low loads. There is a need to guarantee a minimum participation rate (i.e., a guaranteed minimum percentage of the increase in a standard equity index). There is a need for the participation rate to be based entirely on a formula that removes carrier discretion. There is a need for the formula to take advantage of the unique economic benefits available to individuals (e.g., participants in savings programs) by pooling their collective contributions (both from previous years and the current year).